LULU: Early Cycle Company Acting Mid Cycle-ish

The store growth slash overwhelmed the fact that the company managed its business like a retailer who has been in business for 30 years. As growth investors cycle out, this name is a gift.

What a flat-out weird quarter from LULU. Truly. Expectations were for a miss due to weaker comps, eroding gross margins, higher SG&A due to ERP investments, and inventory build. In actuality, the P&L looked better, the balance sheet looked exceptional, but store growth expectations were decimated. Bears definitely right on this puppy – though most probably for the wrong reasons.

Why do I say that LULU is acting like a mid-cycle company? Two main reasons…

1. The degree to which the company managed its inventories this quarter almost knocked me off my chair. Check out the SIGMA below. For 2 quarters straight, inventories built (and the multiple contracted), but then LULU took a massive V-shaped move to clean its balance sheet at the expense of margins (upper left quadrant). The key point here is that 80% of retailers revert to the lower left quadrant first – i.e. inventories building AND margins down – before taking any action. LULU is a step ahead. That’s unusual for a company like this where people so frequently question managements’ ability to execute.

2. The fact that LULU has secured only 5 real estate locations for next year on a base of 107 at year-end 2008 should scare even the most conservative growth investor at face value. Yes, it scared me as well. For most retailers, this behavior suggests management’s lack of confidence in its own growth platform. I don’t think this is the case with LULU. But it does show that the store growth strategy is part offense, and part defense.

a. The defensive angle is that company realizes that it does not live in a vacuum, and investing in a declining spending environment is risky business.

b. The offensive angle is that LULU fully realizes the leverage it holds with prospective landlords. LULU is taking a ‘come to Daddy’ approach to secure lower rents, which I like given that it will balance store-level economics as business shifts incrementally from 4-wall to .com.

c. The part of the growth equation that does not sit well with me is that a major theme next year, in my opinion, will be that the power brands that consumers want to succeed that also have the balance sheets to dominate the share-grab game and put weak competitors away will emerge the clear winners. LULU should be one of those. I’d rather see a more aggressive posturing here. They can afford it.

I still like the fundamental story here. Check out my 11/9 Post for the full thesis (I’m Finally On-Board with LULU”).